Financial advisors have an overall positive effect on their clients’ portfolio returns, according to the results of an academic study published in November 2014. The research also found that advisors’ investment biases, as well as mutual fund fees, may have offsetting effects on clients’ portfolios.
The study, entitled Retail Financial Advice: Does One Size Fit All?, was conducted by academics at the University of Western Ontario, the University of Chicago’s Booth School of Business and Northwestern University in Illinois. The researchers examined the impact of financial advisors upon investments and found that clients with an advisor were 30% more likely than clients without an advisor to invest in riskier investment funds, particularly equity funds, after accounting for individual characteristics such as age, gender, occupation, financial knowledge and risk tolerance. Furthermore, the study found that a client’s investment portfolio frequently mirrors the risk profile of the advisor.
Advisors often invest clients’ assets in investments those advisors prefer personally, regardless of the client’s preferences, says Alessandro Previtero, assistant professor, finance, with the Richard Ivey School of Business at the University of Western Ontario and a co-author of the report. For example, advisors who prefer equities will invest their clients more heavily in equity funds.
Previtero adds that this bias often comes as a result of years of conversations between advisor and client, during which the client may be persuaded gradually to invest more heavily in equity funds. “I would recommend,” Previtero says, “that advisors step back and look at the portfolio of the client and see whether [the advisor’s] belief is [affecting] the client’s decisions more than it should.”
Jon Cockerline, director of policy and research with the Investment Funds Institute of Canada (IFIC) in Toronto, views the close relationship between the asset allocation of an advisor’s own portfolio and the asset allocation for his or her clients’ portfolios as a positive finding.
“I think it’s even reassuring, in a sense, that advisors do believe firmly in the products they are advising to their clients, and they show that by investing in those products themselves,” Cockerline says.
The study examined the portfolios of 581,044 clients and 5,920 advisors over a 14-year period. Information was provided by three Canadian mutual fund dealers. (A fourth firm participated in the study, with data for a much shorter time frame.)
Advisors, by steering clients toward the advisor’s preferences, are leading clients to take on more risk, particularly in equity funds, according to the study. This bias can have a generally positive effect on clients’ portfolios because this strategy allows clients to take advantage of the “equity premium.” The study assumes an average equities premium of 6%, enabling clients who invest with an advisor to see returns that are 1.8% higher than clients who invest without advice.
The study’s authors note, however, that this equity premium may be offset by costs. The study calculated that the average investor pays roughly 2.7% in mutual fund fees, including management expense ratios (MERs) and front-end loads.
IFIC disputes the paper’s calculation of fees, arguing that MERs should not be included. All products have a cost for manufacturing and distribution, Cockerline says. He adds that the only fees included in the paper’s calculation should be those paid to advisors, which he would set at 0.5%-0.66%.
While the study found that the fees wipe out any gains made by working with an advisor, the paper proposes that it’s likely that clients will continue to work with or seek out advisors because of other services they provide, such as financial planning and tax planning – or simply for the peace of mind of working with a professional.
Says Previtero: “People might see some benefit from the hand-holding that the advisor provides.”
The Toronto-based Financial Planning Standards Council (FPSC) believes Previtero’s statement is consistent with FPSC’s research. Cary List, president and CEO of the FPSC, points out that the certification body’s 2009 longitudinal study found that clients working with advisors felt significantly more comfortable about their finances – regarding staying on track or being able to handle unexpected events – compared with investors who sought one-time advice.
“Our own studies suggest that there is more and more an expectation and huge inherent value in the planning side of the equation,” List says.
Previtero believes his study’s findings represent a strong argument for transparency and for more discussion regarding fees, and not simply reducing or banning fees.
Cockerline agrees that transparency regarding fees is necessary and believes the implementation of the second phase of the client relationship model (CRM2) will help to move the industry in that direction.
“The market is evolving,” Cockerline says, “and a model that is working already is going to work even better as these new regulations come into affect.”
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